June 06, 2012
Aggregate factors in the price of oil
It seems that no matter what financial series you look at, there's a similar pattern of ups and downs over the last few years. I was curious to get a quick quantitative impression of how much of a contribution aggregate factors have been making to recent movements in the price of oil.
I commented on Sunday on recent big swings in stock prices, which rose in the fall of 2010, declined sharply over sovereign debt worries last summer and fall, rebounded early this year, and over the last month have moved back down. The same basic patterns are seen in the dollar price of oil.
How much of the recent moves in oil prices can be explained by changing perceptions of global economic activity? One way I thought to get an impression of this was to look at the extent to which recent oil price movements are mirrored in other commodities. I was able to assemble a quick data set on spot prices for copper, corn, palladium, platinum, soybeans, and wheat, and calculated the principal component of the weekly percentage changes in these 6 commodity prices over January 2005 to September 2011. The value of this principal component for any particular week in fact turns out to be pretty close to the average change across the 6 commodity prices for that week. I'm a big believer in using parameters that are a priori plausible values in preference to over-fitting a given sample, and the principal components analysis suggests that a simple average would be an excellent summary statistic to use for these purposes.
I then regressed the weekly percentage change in the price of crude oil on the average change for the other six commodities over that same week, and came up with a coefficient of 1.15. Again the principle of parsimony suggests that a value of 1 is a pretty good a priori reasonable value to use to represent that regression. That gives me then an extremely simple-minded way of answering the question, that in fact is pretty close to what an exact fit to the historical data would lead you to choose, namely, the predicted percentage change in oil prices this week is just the average percentage change observed for other commodities over this week.
The black line in the graph below shows what happened to the actual price of oil since September 2010. The green line is the price you would have predicted since 2010 if you knew nothing other than what happened to other commodity prices since 2010 and assumed that oil would do exactly the same thing as other commodities. An increase in the price of oil from $80 to $100 in the last quarter of 2010, followed by a decline back down to $80 in the fall of 2011, would have been exactly in line with what happened to other commodities. One need appeal to nothing special happening to the oil market over this period, other than an increase in demand for oil along with other commodities as prospects for global economic growth first picked up and then declined.
What we've seen since last fall, however, is a little different. If oil had risen no more than these other 6 commodities, it wouldn't have gone above $93 at its peak in March. More than half of both the move up in the price of oil at the start of this year, as well as of the sharp drop in the price of oil over the last month, may reflect influences specific to the oil market.
Among those factors, efforts by refiners to find alternative suppliers for boycotted Iranian production played a role, though I'm wondering what others see that I don't suggesting that tensions in Iran are now settling down. There are also some moderately encouraging developments in recent production numbers.
But I think the basic impression from the first two figures plotted above is correct-- much of the drop in oil prices over the last month is a response to a worsening outlook for global economic activity.
Posted by James Hamilton at June 6, 2012 06:00 AMdigg this | reddit
Along similar lines there are some remarkable asset price correlation heatmaps at this FT Alphaville post:
Posted by: Stuart Staniford at June 6, 2012 07:23 AM
Given that US refined product prices seem to track Brent much more closely than WTI, I would have been inclined to correlate Brent prices, but in any case, I agree that the decline in oil prices is certainly tied to the outlook for global economic activity.
Regarding the supply side:
Five annual "Gap" charts follow, showing the gaps between where we would have been at the 2002 to 2005 rates of increase, versus the actual data in 2010 (common vertical scale).
The EIA data for total liquids and for crude oil show virtually no change in annual production from 2010 to 2011. We don't yet have the BP data base, so I can't yet update the total petroleum liquids numbers and net export numbers.
EIA Total Liquids (including biofuels):
BP Total Petroleum Liquids:
EIA Crude + Condensate:
Global Net Oil Exports (GNE, BP & Minor EIA data, Total Petroleum Liquids):
Available Net Exports (GNE less Chindia’s net imports):
I would particularly note the divergence between the first chart, Total Liquids, and the last chart, Available Net Exports (ANE).
I estimate that there are about 157 net oil importing countries in the world. If we extrapolate the Chindia region’s rate of increase in their combined net oil imports, as a percentage of GNE, in 18 years, around 2030, just two of these oil importing countries--China & India--would consume 100% of GNE.
Posted by: Jeffrey J. Brown at June 6, 2012 08:07 AM
I suggest you use the CRB:index of industrial raw materials as your index for non-oil commodity prices. For many years I have found it to be an outstanding leading-concurrent indicator of oil prices.
Posted by: spencer at June 6, 2012 08:43 AM
Post makes good sense.
I agree with Stuart in that I would use Brent as well. WTI was a roach motel during the period referenced and prices were affected as much by US pipeline dynamics as world crude dynamics. I think the Oil beta to the commodity basket is maybe a bit higher than 1.15 if you use Brent.
Any comments on Ed Morse's 2020 piece on N American crude production growth?
Posted by: Cello2econ at June 6, 2012 10:50 AM
There are essentially two components to the price of oil (as well as other commodities) there is the demand component and the monetary component. It is not surprising that oil would move with other commodities because when the monetary component is dominant all commodities would be influenced.
Earlier in the year there was a pull and push on the demand side. Tensions in the ME especially Iran were pulling the price upward while the economic bust was pulling the price downward. The result was a slightly undervalued price of oil with the bust slightly stronger than the unrest.
With the easing of ME tension and the growing concern with the EU, US employment, a looming US tax disaster and other restrictions on growth the demand side was manifest in a strong way.
But the price of gold jumping back over the $1,600 level is indicating that traders believe that, due to such bad economic numbers, the FED will return to some kind of easing soon. That means that the price of oil is due for another rise.
But another Debt Ceiling showdown in the fall could throw everything for a loop.
Posted by: Ricardo at June 6, 2012 10:59 AM
If you believe in price inelastic demand, then you have the basis for endogenously created oil price shocks. Demand in the short term doesn't react quickly enough.
For countries with optimism about the future or an ability to borrow, oil prices will rise above long term sustainable levels in the absence of supply give.
This properly characterizes China, I think, in the post 2009 period. Oil prices clearly surpassed China's carrying capacity, which is probably in the $112-117 range Brent. As a consequence, China's demand stalled out in April, reflecting either a collapse in optimism about the future or a lack of borrowing power at the consumer level. I think the former is more likely. Thus, this interpretation suggests that high oil prices have been making Chinese rethink their future. We can see this in auto sales, for example, which grew only 2.5% in 2011 and are expected up only 5% this year. Essentially China is where S. Korea found itself in 1981--a fast developing country facing oil supply constaints.
Now emerging market demand should be increasing by i) the increase in the oil supply + ii) the decrease in OECD oil consumption.
We can use China as a proxy for emerging markets and the US for the OECD (a simplification, but it is simple). So China's demand should be increasing by (approximately) 1/2 of oil supply growth + the decrease in US consumption.
US consumption has been falling like a stone, as much as 5% in March. To keep everyone happy, US consumption should be falling no more than 1.5%. Now China's demand is also flat, so this suggests global demand will fall, and this will lead to oil price weakness.
How long and far the oil price falls is open to question. If there is a recession a la ECRI, the the oil price has a good bit further to fall, perhaps below $50 for a period. If there is only a period of softness, then the oil price should not fall much farther than it has now. We might see the oil price in the $70s for a while, but this would represent a "buy" signal, not a collapse of oil prices or demand. The US can probably sustain $90 Brent, the Chinese should be able to handle $110. Average it out, and $100 Brent should not be unattainable. If there is no recession, I would anticipate weakness would last only a few months, maybe 3-5, as low prices spark the US and Chinese economies.
The Obama administration must bank on a relatively short trough, with lower oil prices stimulating the US economy and providing some positive momentum into the November election.
I am inclined to think weakness without recession, but I am no more clever on Europe than anyone else. I think Greece exits, but I have really no clear idea of how it all plays out.
In any event, timing matters a lot here. If economic weakness persists, Obama is toast. On the other hand, if low oil prices stimulate the US economy and create a little cheer among consumers, Obama might be able to ride the trend line. The constellation of electoral votes favors Obama, thus with a little tail wind he might squeak in.
But time is running short.
Posted by: Steven Kopits at June 6, 2012 11:01 AM
Steve Kopits: i think if oil prices fall becasue of falling demand due to economic retrenchment (As Prof H is pointing out), it will be reflected in higher unemployment. If oil prices fall due to increased supply, then consumers will be cheerful.
Posted by: Pierre Charles at June 6, 2012 01:01 PM
JDH much of the drop in oil prices over the last month is a response to a worsening outlook for global economic activity.
I'm not disagreeing with you here, but doesn't the close connection between oil prices and other commodity prices, and the acceptance that both are moving in response to expected real economic growth at least somewhat undercut some of your earlier posts that suggested a rise in commodity prices would signal when the Fed's QE policies had done about as much as they could? Okay, that's a long sentence, so let me restate things. In those earlier posts you seemed to be saying that commodity prices were moving with inflationary expectations, but those expectations were based on the limits of QE policies rather than reflecting any expectations for big growth. Here you seem to be saying that commodity prices are more grounded in expectations of real economic activity.
Posted by: 2slugbaits at June 6, 2012 01:48 PM
What happens if supply for oil increases suddenly as it has for natural gas?
I know the Malthusians out there will point to King Hubbard and say the sky is falling, but what if it isn't? What if there were a few trillion barrels of the black stuff sitting around for a nation dependent on energy exporting to start doling out?
Just saying... what if?
Posted by: Bruce Hall at June 6, 2012 03:05 PM
Pierre - Yes, I agree. I think Jim has the analysis right. I just added some color.
Bruce - For the liquids supply to increase suddenly, marginal costs have to fall below $100 / barrel, where they seem to be, even in the Bakken. Or conversely, you could have a very large resource at the $100 level, in which case you'd get a lot of production, but it would be quite price sensitive.
To really get a boost in production at a low price, you'd need a better technology than hydrofracking and horizontal drilling and you'd need to get extensive international adoption.
I think a more plausible scenario is the rapid adoption of natural gas as a transportation fuel. That would lead to falling oil production potentially, but more, lower cost fuel.
Posted by: Steven Kopits at June 6, 2012 03:47 PM
"Pressure pumping prices, which cover a range of costs associated with fracking a well, have already dipped by up to 25 percent in natural gas-rich basins, with signs of a knock-on effect emerging in the Bakken, according to Barclays analysts. Within the next six months, these costs could fall by as much as 10 percent in the Bakken shale, analysts at Bernstein Research estimate.
Efficient forms of fracking are also helping companies extract more oil from each well, lowering the break-even cost of production, now estimated between $55 and $70 a barrel."
I'm not sure where the $100 per comes from, but as with most new technologies, the cost of products rapidly falls for the first decade of serious production.
Posted by: Bruce Hall at June 6, 2012 06:20 PM
Very good oil & gas conference in NYC on June 19th.
Posted by: Jeffrey J. Brown at June 7, 2012 03:14 AM
Many thanks for this truly educative post and the edifying comments (two in a row inclusive of
M Chinn last post conclusion).The casuists are spoiling the readers.
"though I'm wondering what others see that I don't suggesting that tensions in Iran are now settling down."
Wag the Dog (1997)
Posted by: ppcm at June 7, 2012 04:50 AM
Yes, we will become more efficient in extraction. But shale wells are characterized by very high initial production and very high--often 65-90%--decline rates in the first year. Increasing production doesn't mean using the same rigs over and over; it means you have to keep increasing the number of rigs. We're going to see issues with a declining number of "sweet spots" and delays caused by permitting and other factors. So you can't take the first three years' production and extrapolate that growth out forever. Not for shale/tight oil wells. Rather I would anticipate very quick initial growth (first 3-5 years of real production) and then a flattening of growth relatively quickly.
I think shale oil is helpful, but the US and Canada alone cannot meet the growing energy needs of China and the emerging markets. So we need international dissemination of the technology, which still seems to be several years off.
If you're interested, come to the oil wildcards symposium of June 19th. We'll have Ed Morse of Citi arguing the "pro" side and George Littell of GLL arguing the "con" side.
Posted by: Steven Kopits at June 7, 2012 06:26 AM
Thanks for the invite, Steven. Unfortunately will be at 35k enroute from SF to Detroit.
Have fun out there. Obviously the debate is not "settled" and there is not a "consensus."
Posted by: Bruce Hall at June 7, 2012 08:18 AM
All forecasts are made within a given state of knowledge, including technological, geological and political considerations. Any changes in these will change a forecast.
From my perspective, this issue is not so much "what will happen?" as "what should we do?".
We routinely advise on substantial private equity and M&A transactions in oil field services. Our clients include TPG, KKR, First Reserve, Carlyle and many others, and these transactions run from the $10 of millions to the multiple dollar billions.
I cannot claim to reveal the "truth" to my clients, only to make the best case possible out of the data available.
When it comes to natural gas, for example, I have expressed my reservations about the viability of Arctic projects like Shtokman, MacKenzie Valley, and Prudhoe Bay gas. Until we know how China's shale gas will play out, I would be cautious on high cost gas plays. And FYI, Shell has just requested proposals for a FEED (front end engineering and design) study for a shale gas field in Sichuan, China.
One could also make the same case for oil in Alaska's Chukchi and Beaufort Seas. If you think oil's going to be cheap and plentiful, then the case for Alaska is pretty weak. That's why Shell didn't develop those fields for twenty years--not because they didn't know the resource was there. So should Shell spend $20+ bn on developing Alaska? In my view, yes. Indeed, it is a critical resource and we should accelerate its production. (See this space next March.)
On the other hand, if you think the world will be awash in cheap oil, then you would pass on the project.
So the issue is not who's right. It's about what we should do. What do you want to do?
Posted by: Steven Kopits at June 7, 2012 09:10 AM
You are certainly correct in pointing out that forecasting is easy [and easily wrong] while decision-making is precarious and difficult when so much is at stake.
The biggest variable, as I have pointed out in many comments, is government. Having all of the coal needed to power electrical plants for centuries is of no value if the leader of the government wants to "bankrupt coal." Political uncertainty is what makes any forecast suspect... and any decision subject to second-guessing in 5 or 10 years.
What do I want to do? Scale back government interference in the marketplace. I know that will displease Menzie and Company who view such interference as necessary and justified to protect us from ourselves.
Posted by: Bruce Hall at June 7, 2012 09:50 AM
Perhaps the fear factor of violence over Iran?
As I read your chart, the price of oil appreciates above the index from about Sep-Oct 2011, and then depreciates down to the level of the index from about Apr-May 2012.
This correlates pretty good with the hard talk given by PM Netanyahu vs Iran over the winter, and the the contrary talk form the Israeli security and defence establishment given later in the winter and spring.
The supply constraints from Iran probably also plays a role, as you mention.
Another factor may be a risk premium in other markets, from producing countries to risk for shipping companies.
Furthermore, there is an inverse relationship between oil and dollar. Perhaps this is stronger for oil than other commodities? Could that, in case, be tested?
Lastly, I agree with a few other commentators that it would be interesting to also have a look at the Brent price. If only to whether it may make a difference or not.
Posted by: Tord Steiro at June 8, 2012 05:01 AM